The arrival of a new year means that another proxy season is not that far off.  A highlight of the 2011 proxy season was that it marked the first year in which shareholder advisory votes on executive compensation (“Say on Pay”) were conducted in accordance with the Dodd-Frank Act.

While it is true that the vast majority of companies received favorable Say on Pay votes in 2011, even those companies who garnered a large percentage of affirmative votes will not want to become complacent particularly since most companies opted for annual frequency of Say on Pay votes meaning that they will again be holding Say on Pay votes in 2012.  In this regard, aligning executive pay with company performance appears to increasingly be a major focal point with respect to Say on Pay votes.  Moreover, the Dodd-Frank Act specifically will require companies to disclose and report on the relationship between CEO compensation and the company’s performance including stock price changes.  The Securities and Exchange Commission (“SEC”) has stated on its website that it expects to propose regulations to implement this statutory requirement in the first half of 2012.  Note though that this disclosure requirement has been the subject of several comment letters to the SEC and there have been efforts to entirely repeal this disclosure requirement (see for example H.R. 1062: Burdensome Data Collection Relief Act).

While the SEC’s pay for performance regulations may not be effective in time for the 2012 proxy season, it does not mean that the alignment between executive pay and company performance is not being scrutinized.  In December 2011, Institutional Shareholder Services Inc. (“ISS”), a proxy advisory firm, released a comprehensive white paper (“Evaluating Pay for Performance Alignment”) detailing its new pay for performance evaluation processes that will be effective for the 2012 proxy season and which ISS will utilize to evaluate whether or not a company’s executive compensation practices are in proper alignment with its performance.  In its white paper, ISS noted that 94% of the institutional respondents to one of its policy surveys indicated that pay for performance is a critical/important consideration with respect to their Say on Pay vote determination.

ISS Evaluating Pay for Performance Alignment White Paper

The ISS white paper is detailed and contains a fair amount of complexity.  The discussion below is necessarily just a brief overview and the white paper provides much more details and rationale for the ISS methodology.  In a nutshell, the ISS methodology focuses on CEO pay and quantitatively compares it to long term total shareholder return (“TSR”).  If the quantitative analysis indicates that there may be misalignment, then ISS will perform an in-depth qualitative review to determine either the likely cause of a perceived long-term disconnect between pay and performance, or factors that mitigate the initial quantitative assessment.  If after these evaluations have been completed, ISS believes that the company’s executive compensation pay practices are an outlier then this, in their view, means that shareholders of such company may want to communicate their concern to the company about its pay-setting and could potentially cause ISS to recommend voting against the company’s Say on Pay proposal.

In performing its quantitative assessment, ISS looks at the following three measures:

  • Relative Degree of Alignment (“RDA”) – Comparison of CEO pay and TSR, relative to an ISS selected peer group, over one and three year periods
  • Multiple of Median – Relative comparison of the CEO’s pay to the peer group median pay for the same time periods
  • Pay to TSR Alignment – An absolute comparison of the trends of the CEO’s annual pay and the Company’s TSR over prior five year period

The ISS generally uses the Company’s publicly disclosed compensation data in SEC filings with respect to CEO pay numbers.  The peer comparison group is selected by ISS and generally consists of 14 to 24 companies which are intended to be similar in terms of size, industry and market capitalization over one and three year periods.  The ISS constructs peer groups for all Russell 3000 companies twice per year utilizing Global Industry Classification Standard (“GICS”) classifications and revenue/total assets and market value data.

ISS back-tested their pay alignment methodology using historical data.  The white paper states that the three quantitative measures were statistically significant predictors of Say on Pay votes, especially the RDA measure.  The white paper also states that companies whose quantitative assessments indicated that there was high concern for potential misalignment between pay and performance received fewer affirmative Say on Pay votes than companies which ISS determined were low concern companies.

After computing the three quantitative measures, ISS evaluates the results to see if there is a concern that the company’s pay for performance practices are not in alignment.  If the quantitative analysis indicates significant misalignment, then ISS will perform a qualitative analysis on some or all of the following:

  • Strength of Performance – Review of the ratio of performance to time based awards along with the overall ratio of performance based compensation to total compensation
  • Company’s Peer Group Benchmarking – Review the company’s selected peer group to see if the company is benchmarking to larger companies that are resulting in inflated compensation
  • Financial/Operational Metrics – Evaluate the rigor of the company’s performance goals upon which the compensatory payouts are based
  • Special Circumstances – Assess any special circumstances (e.g., the hiring of a new CEO in the prior fiscal year) that could distort the quantitative analysis

Summary

Pay for performance will continue to be the mantra of corporate governance advocates and the subject of scrutiny by proxy advisory firms and institutional investors.  Therefore, among other things, companies may wish to examine the ISS white paper and assess how their pay for performance practices would be measured under the white paper’s methodology.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.